How can the insurance industry's record losses from natural disasters in recent years be reduced? Howard Kunreuther has some solutions

The insurance industry is gravely concerned that it cannot provide protection against catastrophic risks from natural, technological and environmental hazards without exposing itself to the danger of insolvency or significant loss of surplus.

Before 1988 the insurance industry worldwide had never experienced a loss greater than $1 billion from a single event. Since then there have been 15 natural disasters which have exceeded this figure. Topping the list is Hurricane Andrew which swept the Florida coastline in August 1992, causing $15 billion worth of damage. If the storm had taken a more northerly track, hitting downtown Miami and Miami Beach, total insured damage could have approached $50 billion. Insured damage from the Northridge earthquake in southern California exceeded $12 billion. Had a similar quake hit central Los Angeles the insured bill could have been over $50 billion.

Although the insurance industry has suffered record losses from catastrophic events in recent years, most of the damage has been covered from other sources of funds. For example, in 1995 total estimated losses from natural disasters around the world accounted for $150 billion, exceeding by ten times the insured losses of $14.6 billion. More than half this amount was accounted for by the Kobe earthquake where damage was estimated at over $82 billion, although insured losses were only $2.5 billion.

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How does one explain this large difference between insured and actual losses? Few property owners voluntarily purchase coverage or invest in loss reduction measures as protection against such low probability but high consequence events. In other words, most insurance is bought only because one is required to do so. For example, banks and financial institutions normally require cover against fire and wind damage as a condition of granting a mortgage.

Why is there is so little interest in protection? Two factors stand out from empirical studies. An individual residing in a disaster-prone area still feels that these events will "not happen to me"; hence, why worry about protecting oneself? Only after a disaster is there interest in purchasing insurance or making one's home safer, but by then it is too late. A second factor which inhibits these expenditures is that most people have budget constraints. Purchasing insurance or investing in making one's home safer is normally not top priority.

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Society has a severe problem managing catastrophic risks. The cost to the general taxpayer of these events is rising at a rapid rate. In the United States the federal government spends more on natural disasters than on running the federal court system, aiding higher education and pollution control combined. Other countries undoubtedly have a similar story to tell. When a disaster strikes and victims have no financial means of recovering, then there is a natural tendency to want to assist them. As a result the public sector comes to the rescue.

Fortunately, it is possible to think more broadly about managing these risks in the future. This is due to advances in information technology for analysing and manipulating data, and the availability of new financial instruments for supplementing traditional reinsurance. These developments suggest a strategy which includes the following elements.

First, risk estimates can be improved. Advances in information technology allow us to estimate more accurately the chances and potential losses of future disasters and catastrophic events. More powerful computers enable us to examine extremely complex phenomena in ways that were impossible even five years ago.

Scientific advances in risk assessment have also reduced the uncertainty associated with predicting the chances and consequences of these low-probability, high-consequence events. Hence insurers can develop strategies for better management of their portfolios than by relying on historical data, as they have traditionally done.

Second, better use of audits and inspections. One way to encourage the design of structures that are more resistant to future disasters is to develop building codes and provide a seal of approval for each structure that meets these standards. To institutionalise such a procedure financial institutions could require an inspection and certification of the facility against natural hazards as a condition for obtaining a mortgage.

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The success of such a programme, which would be a form of buyer protection, requires the support of the building industry and a cadre of well-qualified inspectors to provide accurate information as to whether existing standards are being met. To reduce their losses from disasters, insurers may want to limit coverage to those structures that are given a seal of approval.

Third, broadened protection against catastrophic losses. Over the past few years a number of new financial instruments in the form of derivatives have been developed for dealing with catastrophic losses, although to date they have had limited market penetration. These instruments infuse the insurer with additional capital should there be a catastrophic loss. In this sense they represent diversification of assets over time rather than across geographical boundaries. Insurers could supplement traditional reinsurance with these guaranteed sources of funds in order to enable them to offer coverage in high-risk areas where they feel constrained today.

Some of these instruments provide funds to the insurer should they suffer a catastrophic loss. J. P. Morgan and Nationwide Insurance successfully negotiated such a transaction whereby Nationwide borrowed $400 million from J. P. Morgan which is placed in a trust fund composed of US Treasury securities. Nationwide pays a higher than normal interest rate on these funds in return for having the ability to issue up to $400 million in surplus notes to help pay for losses should a catastrophe occur.

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Another option is for government to provide reinsurance protection against catastrophic losses. Private insurers would build up the fund by being assessed for premium charges in the same manner that a private reinsurance company would levy a fee for excess loss coverage or other protection.

The advantage of this approach is that resources at the government's disposal enable it to cover catastrophic losses without charging insurers the higher-risk premium that private investors would require. However, if one views the private sector as the first line of attack, then one would only want to resort to federal reinsurance as an avenue of last resort.

This is a very exciting time for the private and public sectors to explore new opportunities for dealing with catastrophic risks. If insurance can be used as a catalyst to bring other interested parties to the table, it will have served an important purpose in helping both the industry and society deal with the critical issue of reducing losses and providing protection against natural, technological and environmental disasters.

Howard Kunreuther is the Cecilia Yen Koo professor of decision sciences and public policy, Wharton School, University of Pennsylvania, and co-director, Wharton Risk Management and Decision Processes Center.

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